Credit Rating Agency Problems

I’ve seen a lot of discussion of the credit rating agencies (S&P, Moody’s, Fitch). There are various lawsuits against some of them for their role in the housing bubble and bust.

S&P downgraded the rating of US Treasury debt. Now, S&P is being investigated/prosecuted more harshly than the other credit rating agencies. Is that retaliation for the Treasury debt downgrade?

One issue is freedom of the press. A credit rating agency should be free to say whatever they want.

The problem is caused by current law. Certain investment funds are only allowed to invest in high-rated debt. Insurance corporations are required by law to invest most of their assets in “investment grade” debt; there may be similar restrictions in other areas.

This leads to the obvious problem. If an issuer can get a high rating for its debt, then more people are legally allowed to buy it.

The credit ratings are not impartial 3rd party evaluations. Instead, the debt issuer hires one of the credit rating agencies to rate its debt. If S&P gives a bad rating on one bond, then the bank may choose a different rating agency for the next issue. This leads to the credit rating agencies not competing with each other on price or quality of rating. Instead, they’re competing to see who can bend over backwards the most to give debt a high rating, so that banks will choose them.

Also, there are only 3 big credit rating agencies, forming a cartel. Even if I can rate bond better than the big three, I’m not able to start a new credit rating business.

There is another problem. Credit rating agencies are not liable, if their rating turned out to be wrong. In a really free market, I’m only going to trust a credit rating if it’s backed by a guarantee. The person making a credit rating should also take partial responsibility if there’s a default.

There are lots of problems with the credit rating system. The credit rating agencies are chosen by the bank issuing the debt. They inflate credit ratings, to keep the business coming from banks. The big 3 credit rating agencies form a cartel. The credit ratings are backed by various laws, which provide further incentive to inflate ratings. The credit rating agencies are not liable if their rating is wrong. This is not a “failure of the free market”, because the current system of credit ratings is not a free market.